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Monthly Archives: October 2014

As everyone with a computer knows, the web is shoulder-deep in brokerages, services, and publications that promise to help you invest just like the pros. That’s no surprise. It’s a logical step in the democratization of information. On a technological landscape where anybody can become a self-made journalist, filmmaker, or detective, what’s stopping anyone from becoming an armchair investment whiz? The availability of bargain-basement commissions on trades, broad access to research, and specialized trading platforms make it seem like Wall Street’s advantage over the individual investor has never been more negligible.

The only problem is, all those bells and whistles can obscure the fact that there’s still a big difference between what professional traders can do and what individual investors can—and should be doing.

Many of us are do-it-yourselfers by nature and find it rewarding to build our own investment portfolios. The key is to be mindful of the following caveats:

1. Individual investors have an awful track record with short-term trading.

There is research suggesting that different tactical strategies can improve returns. Nonetheless, the performance history of individual investors clearly demonstrates that the majority of investors would be far better off by avoiding short-term trading and just consistently investing.

2. Your tools are no match for the pros.

The short-term behavior of markets is complex and there are thousands of highly-paid PhD quantitative analysts and MBAs spending all of their time figuring out how to gain an edge. These people have lots of time and limitless computer power at their disposal. The idea that a nifty new charting tool can somehow help you to beat these people is naive.

3. You need to win in the long-term not the short-term.

Professional traders focus on the short-term because they are judged and compensated based on recent performance. Many probably realize that short-term trading has low odds of success, but that is the field in which they compete. Individuals need to perform well in the long-term and don’t need to try to compete for short-term results.

4. Being a savvy consumer doesn’t make you a savvy investor in consumer stocks.

Peter Lynch famously advocated that people should ‘buy what they know.’ If you are an avid Facebook user and you see the growth potential, this might be a good reason to invest. On the other hand, stocks of companies with great products often trade at very high prices relative to earnings.

5. Excessive short-term trading can leave you with a huge tax bill.

As detailed in last week’s blog, selling an investment that you’ve held for less than a year at a profit triggers short term capital gains, and you want to avoid that as much as possible. That’s because short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. For investors in the highest marginal income tax bracket, taxes on long-term capital gains top out at 20%, but short-term capital gains can reach 39.6%.

6. It’s tough to know the difference between skill and luck.

Almost everyone who lived through the .com bubble that ended in 1999 remembers people who thought that they were market whizzes because they owned tech stocks when the market was rising and went ‘all in’ on the tech boom. The true test of expertise was choosing to get out when market levels reached ridiculous highs. When you keep making winning bets in a rising market, it’s easy to convince yourself that you are a savvy trader.

Individual investors with a DIY approach can achieve superior results. With an up-close-and-personal eye on such issues as risk tolerance, cost, and tax consequences, individual investors may in fact be uniquely positioned to look after their own best interests. The key is in understanding what kind of investing will work best for you. Investing for the long term with a steady, consistent hand is in your best interest. Trying to compete against Wall Street is not.

This is the eighth installment in our series on how individual investors can assess their financial health

With investment gains, as with other types of income, it’s not how much you make that ultimately matters, but how much you keep. In other words, you only get to spend what’s left after you pay taxes. There are various ways to make your investments tax efficient, and it’s crucially important that you know what they are.

To make sure you don’t incur an excessive tax bill from your investing, take the following steps:

1) Avoid realizing short term capital gains.

2) Make full use of tax-advantaged accounts.

3) Harvest your losses.

4) Match assets to account type.

5) Choose tax efficient mutual funds.

Avoid Realizing Short Term Gains

Selling an investment that you have held for less than a year at a profit triggers short term capital gains, and the tax rate for short term gains is markedly higher than for long term gains. Short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. The difference between the tax rate on your long term versus short term gains depends on your tax bracket, but it is usually sensible to hold investments for at least a year, although this must be considered in light of the need to rebalance.

Make Full Use of Tax-Advantaged Accounts

There are a number of types of investment accounts that have tax advantages. There are IRAs and 401(k)s, which allow investors to put in money before taxes. These accounts allow you to defer taxes until you retire, whereupon you will be taxed on the money that you take out. By paying taxes later, you get what amounts to a zero interest loan on the money that you would ordinarily have paid in taxes.

Another alternative is Roth IRAs and Roth 401(k)s. In these accounts, you put money in after tax, but you are not taxed on the future gains. If you have concerns that tax rates will be higher in the future, the Roth structure allows you to essentially lock in your total tax burden.

529 plans for college savings have tax advantages worth considering. While you pay taxes on 529 contributions, the future investment gains are not taxes at all as long as the money is used for qualified educational expenses. There may also be additional state tax incentives offered to residents, depending upon your home state.

Harvest Your Losses

If you make a profit by selling a security, you will owe taxes on the gain. However, if you sell security in a taxable brokerage account at a loss, the loss can be used to offset realized gains and can even offset up to $3,000 in ordinary income. If you then wait more than a month, you can buy the same position in the losing security and have reduced or eliminated your tax bill on the gain simply by selling the losing position and then waiting more than a month before buying that security back. Alternatively, you might buy another similar security to the one that you took a loss on and then you don’t have to wait a month. The key in this latter approach is that you can buy a similar but not functionally identical security if you want to take a loss and then immediately buy another security back.

It should be noted that tax loss harvesting does not eliminate taxes, but defers them into the future. In general, paying taxes later is preferable to paying them today.

Matching Assets to Account Type

Different types of investment assets have different tax exposure, so it makes sense to put assets into the types of accounts in which taxes are lowest. This process is sometimes referred to as selecting asset location. Actively managed mutual funds are most tax efficient in tax deferred accounts, as are most types of bonds and other income producing assets. The exceptions are those asset classes that have special tax benefits. Income from municipal bonds, for example, is not taxed at the federal level and is often also tax free at the state level. Holding municipal bonds in tax deferred accounts wastes these tax benefits. Qualified stock dividends are also taxed at rates that are lower than ordinary income, so qualified dividend-paying stocks typically make the most sense in taxable accounts. Real estate investment trusts, on the other hand, are best located in tax deferred accounts because they tend to generate fairly high levels of taxable income.

Choose Tax Efficient Mutual Funds

When mutual fund managers sell holdings at a profit, fund investors are liable for taxes on these realized gains. The more a fund manager trades, the greater the investor’s tax burden is likely to be. Even if you, the investor, have not sold any shares of the fund, the manager has generated a tax liability on your behalf. It is even possible for investors holding fund shares that have declined in value to owe capital gains taxes that result from one or more trades that the manager executed. You can minimize this source of taxes by either investing in mutual funds only in tax deferred accounts or by choosing funds that are tax efficient. Index funds tend to be very tax efficient because they have low turnover. There are also funds that are managed specifically to reduce the investor’s tax burden. One academic study found that funds engaged in tax efficient practices generate higher returns than peers even on a pre-tax basis.

Don’t Pay More Tax Than You Have To

Everyone needs to pay their fair share of taxes. But if you manage your investments with a consideration of tax consequences, you can avoid paying more tax than is required. If the various considerations outlined here seem too complicated, a simple allocation to a few index funds will tend to be fairly tax efficient. That is a reasonable place to start.

An old adage about tax planning is that a tax deferred is a tax avoided. In general, the longer you can delay paying tax, the better off you are. The various forms of tax deferred savings accounts are very valuable in this regard.

While it is more interesting looking for productive investment opportunities, spending a little time understanding how to minimize your tax burden can help to ensure that you actually get to spend the gains that you make.

This is the seventh installment in our series on how individual investors can assess their financial health.

In my experience, I’ve found that many people have no idea how much they’re paying for the privilege of investing. And survey data supports my observations. Ignorance is not bliss. Analysis of investment expenses suggests that many people are probably losing a substantial portion of their potential lifetime investment gains to these expenses—and a considerable portion of them are avoidable.

To understand the true scope of investment expenses, you first need to know the different forms they can take. You’re not alone if you didn’t know about some of these costs.

Brokerage fees – Also known as trading commissions, these are what you pay when you buy or sell securities through a broker. Typically, brokerage costs accrue every time you make a trade, though there are a variety of fee structures.

Mutual fund stated costs – These are the fees that mutual fund management collects for running the fund. They are expressed as a mutual fund’s expense ratio.

Mutual fund trading costs – The costs that funds incur through trading their underlying securities are not included in the expense ratio. They are additional expenses that are passed along to fund investors.

Retirement plan administrative costs – In retirement plans, the costs associated with managing the plan itself are over and above the brokerage fees and mutual fund expenses.

Advisory fees – If you have a financial advisor, he or she may be paid on the basis of sales commissions, a percentage of your assets, or a flat fee.

Cash drag – Mutual funds tend to keep a certain percentage of their assets in cash to support fund share redemptions. These assets are doing nothing, but are still part of the assets subject to the expense ratio of the fund. This is not an explicit fee but it reduces the return of your investment, so I have included it here.

Taxes accrued by the mutual fund – Finally, it’s necessary to account for the tax burden that a fund creates for its investors through the fund’s trading.

The Impact of Fund Expenses

A 2011 Forbes article estimates that the average all-in cost of owning a mutual fund is 3.2% per year in a non-taxable account and 4.2% in a taxable account. This estimate is likely on the high end, but it’s certainly possible that it is accurate. A more recent article estimates that the average all-in cost of investing in an actively managed mutual fund is 2.2% per year, ignoring taxes. But rather than debate these numbers, the crucial question is how much you are spending in your own accounts.

While a 1% or 2% difference in expenses may seem small when compared to variability in fund total returns of 20% or more, the long term impact of those expenses is enormous. Let’s do a little math to show how pernicious expenses can be.

Imagine that you can earn an average of 7% per year in a 60% stock/40% bond portfolio. The long term average rate of inflation in the United States is 2.3%. That means your real return after inflation is 4.7% (7% – 2.3%). If your expenses in a taxable account are as high as the Forbes estimate, you’ll end up with only 0.5% per year in return net of inflation. This implies that the vast majority of returns from stocks and bonds could be lost to the various forms of expenses.

If you find that implausible, consider the fact that the average mutual fund investor has not even kept up with inflation over the past 20 years, a period in which inflation has averaged 2.5% per year, stocks have averaged gains of 8.2% per year. The extremely poor returns that individual investors have achieved over the past twenty years are not just a result of high expenses, but expenses certainly must play a role given the estimates of how much the average investor pays.

A useful rule of thumb is that every extra 1% you pay in expenses equates to 20% less wealth accumulation over a working lifetime. If you can reduce expenses by 2% per year, before considering taxes you are likely to have a 40% higher income in retirement (higher portfolio value equates directly to higher income) or to be able to leave a 40% larger bequest to your family or to your favorite charity.

How to Get a Handle on Expenses

To estimate how much you are paying in expenses, follow these steps.

Obtain the expense ratio of every mutual fund and ETF that you invest in. Multiply the expense ratios by the dollar amount in each fund to calculate your total cost.

Look up the turnover of each fund that you invest in. Multiply the turnover by 1.2% to estimate the incremental expenses of trading. A fund with 100% annual turnover is likely to cost an additional 1.2% of your assets beyond the started expense ratio.

If you use an advisor, make sure you know the annual cost of the advisor’s services as well as any so-called wrap fees of programs that the advisor has you participating in.

Ask your HR manager to provide the all-in cost of your 401k plan.

Add up all of your brokerage expenses for the past twelve months.

Collecting all of this information will take some time, but given the substantial potential impact of expenses on performance, it’s worth the trouble. If, when you add up all of these costs, your total expenses are less than 1% of your assets, you are keeping costs low. If your total expenses are between 1% and 2%, you need to make sure that you are getting something for your money. You may have an advisor who is providing a lot of planning help beyond just designing your portfolio, for example. Or you may be investing with a manager who you believe is worth paying a premium for. If your all-in costs are greater than 3% per year, you are in danger of sacrificing the majority of the potential after- inflation gains from investing.

Conclusions

It is hard to get excited about tracking expenses or cutting costs. The evidence clearly shows, however, that reducing your investment costs could make the difference between a well-funded retirement or college savings account and one that’s insufficient.

Future returns are hard to predict, but the impact of expenses is precisely known. The more you pay, the better your investments need to perform just to keep up with what you could achieve with low cost index funds. This is not an indictment of money managers but rather a reminder that investors need to be critical consumers of investment products and services.

For more analysis of the devastating impact of expenses, MarketWatch has an interesting take.

This is the sixth installment in our series on how individual investors can assess their financial health.

Diversification is a perennial topic among investors, and if it seems controversial at times, that may be due to the fact that people don’t always share the same understanding of what it means. But diversification isn’t about investing in a certain number of securities or funds. And it’s not about investing in every possible security under the sun.

Diversification and Risk

Simply put, diversification is the process of combining investments that don’t move in lockstep with each other. For example, Treasury bonds tend to do well when stocks are falling, and vice versa. Combining stocks and bonds thus helps to limit risk. Bonds also reduce the risk of a portfolio because they tend to be less risky on a standalone basis than stocks.

This brings us to an important point: the aggregate risk/return properties of a portfolio depend not only on the risk and return of the assets themselves, but also on the relationships between them. Determining the right balance among these three factors (asset risk, asset return, and diversification benefit) is the challenge of diversification.

A Diversification Self-Assessment

The starting point in the determining whether your portfolio is properly diversified is to come up with a risk level that matches your needs. I discussed risk estimation in last week’s blog. Assuming you have a target risk level for your portfolio, you can then attempt to determine how to combine assets so as to achieve the maximum expected return for this risk.

The word “expected” is crucial here. It is easy to look back and to see, for example, that simply holding 100% of your assets in U.S. stocks would have been a winning strategy over the past five years or so. The trailing five year return of the S&P 500 is 15.7% per year and there has not been a 10% drop in over 1,000 days. Over this period, holding assets in almost any other asset class has only reduced portfolio return and risk reduction does not look like a critical issue when volatility is this low. The problem, of course, is that you invest on the basis of expected future returns and you have to account for the fact that there is enormous uncertainty as to what U.S. stocks will do going forward. Diversification is important because we have limited insight into the future.

Many investors think that they are diversified because they own a number of different funds. Owning multiple funds that tend to move together may result in no diversification benefit at all, however. A recent analysis of more than 1,000,000 individual investors found that their portfolios were substantially under-diversified. The level of under-diversification, the authors estimated, could result in a reduction of lifetime wealth accumulation of almost one fifth (19%).

Additional Diversifiers

Aside from a broad U.S. stock index (S&P 500, e.g., IVV or VFINX) and a broad bond index (e.g., AGG or VBMFX), what other asset classes are worth considering?

Because the S&P 500 is oriented to very large companies, consider adding an allocation to small cap stocks, such as with a Russell 2000 index (e.g. IWM or NAESX).

There is also considerable research that suggests that value stocks—those stocks with relatively low price-to-earnings or price-to-book values—have historically added to performance as well. A large cap value fund (e.g. VTV, IWD, VIVAX) or small cap value fund (e.g. VBR, RZV) may be a useful addition to a portfolio.

In addition to domestic stocks, consider some allocation to international stocks (e.g. EFA or VGTSX) and emerging markets (e.g. EEM or VEIEX).

Real Estate Investment Trusts (REITs) invest in commercial and residential real estate, giving investors share in the rents on these properties. There are a number of REIT index funds (e.g. ICF, RWR, and VGSIX).

Utility stock index funds (e.g. XLU) can be a useful diversifier because they have properties of stocks (shareholders own a piece of the company) and bonds (utilities tend to pay a stable amount of income), but have fairly low correlation to both.

Preferred shares (as represented by a fund such as PFF) also have some properties of stocks and some of bonds.

Another potential diversifier is gold (GLD).

Diversification Example

To help illustrate the potential value of diversification, I used a portfolio simulation tool (Quantext Portfolio Planner, which I designed) to estimate how much additional return one might expect from adding a number of the asset classes listed above to a portfolio that originally consists of just an S&P 500 fund and a bond fund.

Risk and return for a 2-asset portfolio as compared with a more diversified portfolio (source: author’s calculations)

The estimated return of a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index fund is 6.4% per year with volatility of 13%. (Volatility is a standard measure of risk.) Compare that to the more diversified portfolio I designed, which has the same expected volatility, but an expected return of 7.3% per year, as estimated by the portfolio simulation tool. The diversified portfolio is not designed or intended to be an optimal portfolio, but rather simply to show how a moderate allocation to a number of other asset classes can increase expected return without increasing portfolio risk.[1]

The process of analyzing diversified portfolios can get quite involved and there are many ideas about how best to do so. But the range of analysis suggests that a well-diversified portfolio could add 1%-2% per year to portfolio return.

Conclusions

I have observed that the longer a bull market in U.S. stocks goes on, the more financial writers will opine that diversifying across asset classes is pointless. We are in just that situation now, as witnessed by a recent article on SeekingAlpha titled Retirees, All You Need is the S&P 500 and Cash.

On the other hand, there is a large body of research that demonstrates that, over longer periods, diversification is valuable in managing risk and enhancing returns. That said, a simple allocation to stocks and bonds has the virtue of simplicity and can be attained with very low cost. Diversifying beyond these two assets can meaningfully increase return or reduce risk, but an increase in average return of 1%-2% per year is not going to take the sting out of a 20%+ market decline. What’s more, a diversified portfolio is quite likely to substantially under-perform the best-performing asset class in any given time period.

But over long periods of time, the gain of 1%-2% from diversification is likely to increase your wealth accumulation over 30 years by 20%-30%. This is consistent with the analysis of 1,000,000 individual investors cited above, from which the authors concluded that under-diversified portfolios were likely to reduce lifetime wealth accumulation by 19%.

For investors seeking to diversify beyond a low cost stock-bond mix, there are a number of simple portfolios that include a range of the asset classes discussed here and that have fairly long track records. These are worth exploring as a template for further diversifying your own portfolio.

[1] For details on how the model estimates risk and return for different asset classes and for portfolios, see thewhitepaper I wrote on the subject.

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